UPDATE 1-Hong Kong sticking with dollar peg, in sickness and in health

(Adds analytical background, economist comments)

HONG KONG/SHANGHAI, Oct 25 (Reuters) - Hong Kong's commitment to its 29-year-old currency peg to the U.S. dollar risks making the already pricey city even more expensive as policymakers try to manage a wave of foreign money seeking to cash in on a potential Chinese recovery.

Funds have flowed into Hong Kong since the United States unveiled a third round of quantitative easing (QE3) last month, forcing Hong Kong to protect its currency band for the first time since the global financial crisis.

The Hong Kong Monetary Authority (HKMA) has sold HK$14.4 billion ($1.85 billion) over the past week to keep the currency trading between its target range of 7.75-7.85 per U.S. dollar.

That is a mere fraction of the HK$640 billion it spent stabilising the currency after the collapse of Lehman Brothers in 2008, but policy-makers and analysts expect the foreign money to keep coming, which would require more intervention and could renew speculation about the future of the peg.

Bill Ackman of Pershing Square Capital Management, a hedge fund, has repeatedly said he is betting that the peg will be eliminated, despite strong official backing of the peg and an acceptance by most analysts that it is here to stay.

``There are no alternatives to the peg,'' said Erik Lueth economist at the Royal Bank of Scotland (RBS).

``The negatives outweigh the positives.''


When the HKMA sells currency to protect the peg, it releases cash into the local market. This keeps the currency from appreciating outside the band but can produce inflation as more money chases the same amount of assets, such as property and stocks.

Property prices and consumer price inflation (CPI) are already much higher than they were at the end of 2008, when the last round of sustained intervention helped fuel a broad rise in prices.

``Inflows would further aggravate the existing excess liquidity condition, hence driving demand for property as a long-term hedge against it,'' Christiaan Tuntono, research analyst at Credit Suisse, said in a research note.

The Centa-City leading index (CCL), which tracks secondary private residential property prices in Hong Kong, is at its highest level on record since 1994, although there are differing views on what is driving prices.

``It's hard to say whether the money is flowing into the market,'' said Wong Leung Sing, associate director at Centaline Property Agency, adding property was not a particularly attractive target for short-term or hot money.

``It takes too long to finish property transactions and the transaction fees are just too high. Stock and foreign exchange markets are more likely choices for them.''

Hong Kong also offers investors exposure to the mainland Chinese economy through its stock market and direct investment channels, so any expectation of an improving mainland economy is bound to attract funds into Hong Kong.

Hong Kong- and China-dedicated equity mutual funds inflows totalled $1.3 billion in the four weeks ended October 17, the largest such inflows in Asia ex-Japan (AeJ) over the period, according to statistics from brokerage house Nomura.

And the Hang Seng equity index has been the best performer within AeJ since the QE3 announcement.

The peg is not the sole cause of Hong Kong's inflation -- Singapore, for example, has a freer exchange rate, yet its property prices and other forms of inflation have also increased significantly in the aftermath of QE3.

Lu Jiang, economist at J.P. Morgan, said a tight labour market and high rental demand in Hong Kong maintain upward pressure on prices regardless of outside factors.

Lueth of RBS added the money flowing into property from mainland investors was another factor driving inflation in the city, but said that the phenomenon is more driven by restrictive real estate policy on the mainland than currency speculation.


The issue of capital inflows is not limited to Hong Kong, said Jiang, because the U.S. Federal Reserve's QE3 has caused investors to move funds into other currencies, particularly in Asia.

Emerging economies have complained the quantitative easing in developed countries merely floods their economies with cash and complicates their policymaking, as investors borrow at low rates in the United States and ship the money overseas seeking higher returns.

Other economies in Asia have absorbed some of the impact by allowing their currencies to appreciate against dollar, something Hong Kong is unable to do with the peg.

``This is not going to last a long time, because we see some signals that the U.S. economy is recovering,'' said Jiang. Such a recovery would restore appetite for dollars and take pressure off the Hong Kong dollar, she said.

Some have suggested the Hong Kong dollar would do better pegged to the yuan in the future, given the increasingly close relationship between the Chinese and Hong Kong economies. However, such a link is impossible for now because the yuan cannot flow freely between Hong Kong and China.

Others have suggested that adjusting the peg to eliminate the differential between the Hong Kong dollar rate and the dollar/yuan rate might reduce the amount of inflation Hong Kong imports from the mainland, but Lueth of RBS dismissed this.

``It is completely normal for the poorer economy to appreciate against the advanced economy over time, and that usually works through either the price mechanism or the exchange rate. If the HKD were pegged against the CNY, we would see the same inflation, but it would work through the price mechanism.''

(Additional reporting by Yimou Lee; Editing by John Mair)